Friday, June 27, 2014

The Importance of Rebalancing--a Fair Test

 The American Association of Individual Investors ("AAII"), with its several hundred thousand members, can have an important influence on the behavior of individual investors. Its May 2014 journal  contained an  article entitled "The Danger of Getting Out of Stocks During Bear Markets."  The author compares, over a 25 year period,  three investment strategies, all of which start with 70% in stock funds and 30% in bond funds: 1) selling completely out of stocks after a 20% market decline and reinvesting a year later ("panicking"); 2) holding the stock portfolio throughout ("not rebalancing"); and 3) rebalancing the asset allocation annually ("rebalancing").   The annualized returns were pre-tax. There were no assumed annual withdrawals.  Risk is defined as the standard deviation of returns.

Unfortunately, the author chose an interval of time for his study--end of 1988 to end of 2013-- which is biased in favor of not rebalancing.   At the end of 1988, the Standard and Poor's 500 Index ("the market") was at fair value.  (I use Professor Shiller's CAPE Index for valuation purposes.) At the end of 2013,  the market was 50% overvalued.  With such an increase in overvaluation during the test period one might expect the strategy of not rebalancing to be preferable to rebalancing.

A fair test would be over a time interval that starts and ends at the same relative valuation level. The market was 50% overvalued at the end of 1995.  So I ran a test beginning at the end of 1995 and ending at the end of 2013 using the author's own Excel spreadsheets.  The results over the two disparate time periods are shown below.


                                                 1988-2013                    1995-2013

                                          Return          Risk            Return       Risk    

Panicking                             7.8%         12.6%           4.9%        11.8%

Not Rebalancing                  9.7%         14.2%           8.1%        14.2%            

Rebalancing                         9.6%          12.6%           8.4%       13.1%


Observations:

1) Both test time horizons demonstrate the problem with panicking.   Relative to panicking, rebalancing during the 1988-2013 period resulted in a 23% greater return with equal risk.  During the 1995-2013 period, rebalancing generated a 71% greater return with only 11% more risk than occurred with panicking--clearly a preferable risk/reward pairing.

Unfortunately, many individual investors buy high and sell low.  Flows into and out of equity mutual funds over time confirm this activity.  Panicking epitomizes this behavior.  On the other hand, rebalancing involves selling high and buying low or vice versa.

2)  During the fair test period, 1995-2013, rebalancing generated 4% more return with 8% less risk compared with not rebalancing--thus, rebalancing is the better strategy over this time period!
In his article, the author of the AAII study deconstructed rebalancing as merely a diversionary tactic--discouraging the individual investor from panicking during a bear market. These results above show that rebalancing accomplishes much more.

3)  Even during the author's chosen test period, which I deem biased, the wisdom of not rebalancing instead of rebalancing is debatable.  It really depends on one's risk orientation.  Being risk averse, I prefer rebalancing.  After all, to increase one's risk by 13% to achieve a mere 1% greater return isn't attractive to me.  For some, however, it might be.


Where Are We Now?

Right now, Shiller's work shows the market to be 56% overvalued.  Being a believer in the concept of reversion to fair value,  I am interested in how these three strategies would fare during a period that started with the market  50% overvalued and ended with the market at fair value.  Such a period occurred from the end of 1995 to the end of 2008.  The figures below show the results of this test.

                                                             
                                                      1995-2008

                                                  Return          Risk

Panicking                                    2.6%          12.6%

Not Rebalancing                         5.0%          14.9%

Rebalancing                                 5.8%          13.9%


Observations:

1)  Rebalancing is by far the best strategy among these three.  In comparison with panicking it generates 123% more return with only 10% more risk.  Relative to not rebalancing it returns 16% more with 7% less risk.

2)  The annualized return from the best of these strategies is a mere 5.8%.  That compares favorably with the recent 2.6% yield on the 10 year U.S. Treasury Note  and is why the stock market continues to rise despite its being 56% overvalued.   However, were inflation to reach the Fed's 2%+ objective, and the 10 year note yield rapidly to revert to its norm of 300 basis points above inflation, then a prospective 5.8% return for equities would be deemed inadequate compared with a 5% yield on the 10 year note.  A bear market would likely ensue.

These observations argue for rebalancing now if one hasn't already done so.


















Table 1. Performance of the Three Strategies 1988-2013

Strategy 1:  Panicking:  Annualized return   7.8%    Risk   12.6%

Strategy 2:  Not Rebalancing:  Annualized return   9.7%    Risk  14.2%

Strategy 3:  Rebalancing:  Annualized return   9.6%    Risk    12.6%


Note that panicking  generates only 81% of the annualized return from rebalancing with the same risk.  Therefore, rebalancing is, by far, the better strategy.  From an initial $100,000 invested, panicking ends with a portfolio valued at $702,179; rebalancing  with $1,087,803.  Many individual investors buy high and sell low.  Flows into and out of equity mutual funds confirm this activity.  Panicking epitomizes this behavior--not a good strategy.  On the other hand, rebalancing involves selling high and buying low.  Moral of this story--Don't Panic!

According to this test's results, the wisdom of rebalancing versus rebalancing is debatable. It really depends on one's risk orientation.  I, for one, prefer rebalancing.  After all, to increase one's risk by 12% to achieve a 1% greater return isn't attractive to me.  For some, it might be.

The author deconstructs rebalancing as merely a diversionary tactic -- discouraging the investor from panicking in a bear market.  It does accomplish that, but much more as well.   Unfortunately, the author chose an interval for his study that is biased in favor of holding the stock portfolio throughout without rebalancing (Strategy 2).   At the end of 1988, when the study began, the stock market, as measured by the Standard and Poor's 500 Index, was at fair value.  (I use Shiller's CAPE Index for valuation levels.)  At the end of 2013, it was 50% overvalued. With that kind of increase in valuation, one might expect not rebalancing  to win out over rebalancing.  A fair test would be a time interval that starts and ends at the same valuation level.  Using Shiller's work, the market was 50% overvalued at the end of 1995.  Following are the results for the 18 years from the end of 1995 through 2013 using AAII's Excel spreadsheets.


Table 2.  Performance of the Three Strategies 1995-2013

Strategy 1:  Panicking:  Annualized return  4.9%    Risk  11.8%

Strategy 2:  Not Rebalancing:  Annualized return  8.1%    Risk  14.2%

Strategy 3:  Rebalancing:  Annualized return  8.4%    Risk  13.1%


The results of this fair test  proclaim rebalancing, Strategy 3, to be clearly superior to not rebalancing,  Strategy 2, because the return of Strategy 3 is 4% higher and the risk 7% lower.  And Strategy 3, again, is far better than Strategy 1.

The final table shows the results when the period starts with 50% overvaluation, the end of 1995, and ends at fair valuation, the end of 2008.


Table 3.  Performance of the Three Strategies 1995-2008

Strategy 1:  Panicking:  Annualized return  2.6%   Risk  12.6%

Strategy 2:  Not Rebalancing:  Annualized return  5.0%  Risk  14.9%

Strategy 3:  Rebalancing:  Annualized return 5.8%  Risk  13.9%


As expected, during a period starting with overvaluation and ending with fair valuation,  rebalancing easily trumps not rebalancing.  Annualized return for the former exceeds that of the latter by 16% and the risk is 7% lower.

Where Are We Now?

The methodology behind Shiller's CAPE Index valuation model  is intended to dampen the distorting  effect of the profit margin cycle by taking the average earnings over the last ten years rather than earnings during the last twelve months.   Since I believe in the concept of regression to the mean, this approach is appealing to me.

Shiller's CAPE Index is available for a nominal fee.  While it is not useful for market timing over a short interval of time; it is useful for periods greater than seven years--very important in retirement planning for those with decades to go before reaching retirement age.  It is also useful for selecting test intervals.

Right now,  Shiller's work  shows the S&P 500 Index to be 56% overvalued.  Given the test results above,  rebalancing would be appropriate at this time.





















I

No comments: